One of the most important financial decisions one will make in their lifetime is buying a home. There are many factors to consider when weighing this decision: How much house can I afford? What location makes the most sense? How much of a down payment should I apply to the purchase? What are the financing terms? What are the resale prospects?

In this blog, we are going to break down a common decision that most face: Am I better off continuing to rent or should I buy a home?

To illustrate from a strictly mathematical perspective, let’s crunch the numbers and determine what is generally the better financial decision– using two examples:

The first example being economic conditions from a year ago, and then second example under current economic conditions:

The first example is having a mortgage payment of $2,500 or having a rent payment of $2,000. Which one is better?

Let’s assume John Doe is interested in purchasing a $380,000 home, putting 20% of equity as a down payment ($76,000). This results in a mortgage of $304,000, if we assume a 3.5% interest rate on a 30-year fixed mortgage. This results in a $2,500/month total mortgage payment (principal and interest)– which includes $1,000/month for property taxes and $150/month for homeowner’s insurance.

Let’s further assume the home appreciates at 1.5% per year, and John chooses to sell the house after five years.

After five years and an assumed 1.5% appreciation, the $380,000 home will appreciate to a value of $409,368. After typical estimated closing costs and the remaining balance on the mortgage is paid off, John would pocket approximately $116,000 if he sold the home after five years. Assuming this was his primary home for two out of last five years, and never used as an investment property, then the appreciation is tax free.

If we push this out even further to a ten-year timeframe with the same assumptions, the $380,000 house would appreciate to $447,621 if we continue to apply a 1.5% rate of appreciation. Selling the home, after typical estimated closing costs and the remaining mortgage balance, would result in approximately $185,000 if he sold the home after ten years. Again, assuming this was his primary home for two out of last five years, and never used as an investment property, then the appreciation is tax free.

All things considered, potentially a wise financial decision for John. But what would the numbers look like if he continued to rent, and invested the surplus? Let’s discuss further.

If John continues to rent at $2,000/month, he has no need for a down payment ($76k) and has a $500/month surplus that would have been going towards the $2,500/month mortgage payment.

Let’s assume John decides to invest the $76,000 as a lump sum and the $500/month difference in surplus moving forward. Assuming a 7% return, after five years John will have grossed $145,000 of taxable returns, which is a $29,000 increase from selling the house after five years, but subject to different tax treatment. Even after capital gains tax, this is a significant increase in what John would pocket.

A ten-year timeframe is even more substantial– if John rents and invests the down payment / difference in monthly payments he will gross $237,000 of taxable returns (a $52,000 difference from owning a home / selling after ten years). Even after capital gains tax, this is a significant increase in what John would pocket.

Both do not factor in that renting would not have home maintenance costs, while owning could lead to another few thousand dollars of expenses each year to keep up with the maintenance of the house. Strictly from a financial perspective, renting (assuming these numbers) is the better financial move.

2nd example:

Let’s discuss another example, in a rising interest rate environment. Assuming a $600,000 house (20% down payment of $120k), 7% interest on a 30-year fixed rate mortgage, total monthly payment is $4,360/month. Let’s compare this to a $3,000/month rent payment.

After five years, the $600,000 home, assuming a 1.5% rate of compounded appreciation, will appreciate to a value of $646,000. After typical estimated closing costs and remaining balance on the mortgage are considered, John would gross ~$154,000. Assuming this was his primary home for two out of last five years, and never used as an investment property, then the appreciation is tax free.

Ten years? The $600,000 house, assuming a 1.5% rate of compounded appreciation, would appreciate to $696,000. Selling the home, after typical estimated closing costs and remaining balance, would result in gross $245,000. Assuming this was his primary home for two out of last five years, and never used as an investment property, then the appreciation is tax free.

Now, if John instead invests the $120,000 down payment and systematically saves the “extra” $1,360/month difference, he’d have a balance of ~$267,000 taxable gains after five years and ~$476,000 taxable gains after ten years. (Assuming 7% return). Even after capital gains tax, this is a significant increase in what John would pocket if he rents (and does not own in this hypothetical scenario).

So, strictly from a financial standpoint, with the above assumptions, which are for illustrative purposes only and cannot be guaranteed or consistently predicted, it often makes sense to rent– assuming there is the required discipline involved in investing the potential down payment and difference in rent vs. mortgage payment. It’s important to note that these types of decisions are not based strictly on numbers– and owning a home for many provides stability, comfort, and peace of mind. All these factors must be considered in addition to the numbers in order to make the best decision for you and your family.

Other notes to consider for buying a home:

• Generally, we advise clients to keep their total housing payment less than 30% of their net take home pay. So, if their housing payment (principal, interest, property tax, homeowner’s insurance) is $2,500/month, monthly take home should be at least $8,333.
• Another stress test is to take your gross income times two. This is typically the maximum home value that should be purchased if you want to avoid feeling “house poor”. A bank may approve you for much more, but this is our advice based on what we believe keeps a financial plan running, not how big of a loan a bank will hand to you. If your family makes $300k gross for example, then a $600k home value is what would generally be advised not to exceed.
• It is often advantageous to stay in your home for 5 to 7 years after purchasing in order to properly “break even” — considering costs of purchasing, costs of owning, and costs of selling
• Before buying a home, it’s important to make sure many factors are in alignment. If you’re in a specific location because of a new job– it may make sense to rent for 6 -12 months in order to properly evaluate: Do I see myself at this job long-term? How are commute times? Is there a chance I will be relocated? Are my kids happy in this school district? Too often, we see a house purchased before these questions are properly addressed.

Most clients do eventually decide to own a home, and this guide is meant to inform that a house is not an investment, so the justification for putting money into the home for improvements should be thoughtfully considered as a “lifestyle decision”. This mindset shift often prevents big mistakes.

Home decisions should be lifestyle decisions, not financial decisions. Use financial implications along with other factors to make the best decision for you and / or your family.

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Equilibrium Wealth Advisors is a registered investment advisor. The contents of this article are for educational purposes only and do not represent investment advice.

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